Stocks dipped at the open on Friday as traders worried about contagion in the banking world in Europe, with most concern focused on Deutsche Bank. Although the prices for credit default swaps climbed sharply, there were no definitive signs of pending disasters. By afternoon calm had returned and stocks closed marginally higher. For the week, one that started with the purchase of Credit Suisse by UBS and included all sorts of Fed commentary, including a quarter point increase in the Fed Funds rate, stocks basically ended where they started. Banks stocks, however, generally drifted lower.
Given the inherent leverage in the banking industry and the opaque nature of their asset bases, it is hard for investors to get comfortable. The early concern, the decline in value of Treasury holdings, actually has been a bit ameliorated by the rally in the bond market over the past few weeks. But economic stress heightens risk for certain classes of real estate, crypto, and tech start-ups.
The messaging from Washington has been both confusing and disarming. After the failures of Silicon Valley Bank and Signature Bank, the message early on was that, if needed, all deposits, insured or not insured, would be guaranteed. Of course, neither the President nor the Federal Reserve has the legal authority to do any such thing. Moreover, to do so would simply be bad policy. If all deposits were guaranteed somehow (and I have no idea how), bank managements would have no reason not to take undue risks on the investment side of their balance sheets. To be sure, just as the government stepped in to backstop deposits of the two recent bank failures, the Fed and FDIC have tools available to stem short-term crises. Even allowing a few more banks to be merged or moved into receivership, the current crisis may be contained using existing capabilities.
But that doesn’t mean that skies are clearing. Clearly, higher rates have stressed the financial system. We can see that in many ways. The volatility in the bond market is a certain sign. In a marketplace where 10-basis point daily moves in yield are considered large, gyrations over the past several weeks have often been in excess of 50-basis points. Two weeks ago, 2-year Treasury yields topped 5% for the first time in well over a decade. Right now, they are close to 3.75%. Default rates of low-credit auto loans have spiked. Commercial real estate loans for new office buildings are stressed by lower occupancy and canceled leases. Bond issuance, IPOs, and venture funding are at a standstill.
Banks and corporations have responded by taking steps to insure liquidity. Banks are either borrowing from the Fed or taking back excess funds on deposit there. Some banks holding Treasury securities underwater are using the new Bank Loan Funding Program to get access to more money. Individuals, meanwhile, are withdrawing deposits and seeking higher yields. In some cases, they are moving to banks deemed safer in their own minds, although, at least for now, there doesn’t seem to be any serious risk that one of the larger regional banks is in a stressful condition.
For the economy, this has to mean less loan activity, more hoarding of cash, less investment and higher costs for borrowers. If the Fed wanted to slow the economy, the rising stresses in the financial market are doing the job for them, obviously not in the manner intended.
At every quarterly FOMC meeting, the attendees bring their personal projections in the form of a dot plot graph. The accuracy of these predictions, with hindsight, has been awful. It’s like predicting when it might rain in July. But the dot plots do serve a purpose, as they give us a framework of what Fed officials are thinking at the moment. If their predictions of inflation months from now are still elevated, that suggests they would still like to raise interest rates further, for instance. The dot plots at last week’s meeting varied little from December. Inflation this year is projected to be slightly less, but still over 5%. Projections for 2024 and 2025 were unchanged. All suggested the Fed Funds rate would exceed 5% this year. Some suggested it would exceed 5.5%. This was after the recent bank failures and the marked decline over the past two weeks in bond yields. In other words, maybe one or two more rate increases this year (with an emphasis on one), and no rate cuts until 2024.
Looking at the bond market and at Fed Funds Futures, investors don’t buy that what they hear is what is going to happen. In fact, if you look at Fed Fund Futures, the marketplace says there is an 88% chance of no rate increase at the next meeting in May and a 50% chance that we will see the first cut by July. By year end, the futures market predicts 2-4 rate cuts.
Obviously, both can’t be right, but both can be wrong. The Fed is arguing that inflation remains persistent and probably will remain so until there is material weakness in labor markets. Labor markets have been surprisingly strong for many months, although most of the strength has been in relatively low paying hospitality and restaurant jobs. As the mix changes, wage pressures have weakened. Inflation elsewhere is slowing as well. The weakness in the housing market is still not reflected in the inflation data. It will before long.
Market participants have a very different view. They see the economic cost of financial stress as I have pointed out. They see lower commodity prices, particularly for oil. They see tight money supply constraining activity. They see lower Federal outlays. In essence, the markets are saying that the Fed went too far last week and soon will have to reverse course.
We are more in agreement with the markets than the Fed. The Fed was late raising rates and it is usually late to stop the tightening process. Because it is so data dependent, the Fed is backward looking. It won’t stop until it sees persistent declines in the inflation data, or persistent weakness in the labor markets. Both are notoriously lagging indicators, but because I believe the Fed is wrong doesn’t mean I think markets are right. I think the Fed won’t start cutting rates until it sees real signs of negative economic growth. A recession is more likely today than two weeks ago. But it isn’t certain. Once again, the Fed will look backwards to make its decision. The only way it will accelerate rate cuts is if there is a full-blown financial crisis. That is possible, but by no means certain.
Wall Street will welcome the end of the hiking cycle. It will welcome rate declines even more. Since late last year, we suggested that the first half of 2023 would be volatile. Nothing has changed that view, but we don’t see a crisis that even comes close to what happened in 2008-2009. Banks are in much better shape in the U.S. There may be problems in Europe, but even there, banks are in better shape than they were in the 2010-2011 debt crisis. While regulators missed the impact of lower securities values on some bank balance sheets, ultimately a full-blown crisis will relate to credit quality and the ability of strengthened balance sheets to withstand the risks.
The Fed and markets are way out of synch today. I suspect that by the beginning of summer, they will get much closer. Even with the increasing likelihood of a mild recession, a clearer path to a brighter 2024 will encourage investors as 2023 progresses.
Today, NASCAR legend Cale Yarborough is 84.
James M. Meyer, CFA 610-260-2220